Volatility Could Extend Turbulence Into Friday

Stocks finished with modest losses on Wednesday

U.S. stocks finished with modest losses on Wednesday after struggling to stay in the green for most of the session. In the end, the Dow Jones Industrial Average lost 0.1%, the S&P 500 lost 0.5%, the Nasdaq Composite lost 0.9% and the Russell 2000 bucked the trend, gaining 0.1%.

Overall, the trading action was a lazy back and forth as shell-shocked traders battled between short covering and preparing for another down leg in the selloff that started on Friday. The madness all started with a surprisingly strong jobs report featuring an increase in wage inflation. This raised concerns about a quickening of central bank policy tightening, higher yields and an end to the long cheap money easiness in markets.

A rise in the 10-year Treasury yield to 2.84% closed in on the high hit last Friday suggesting the rates worry is set to be an ongoing headwind here as stocks try to work off the oversold technical condition.

The dollar surged after European officials complained of U.S. Treasury verbal interventions to lower the greenback — a possible sign currency wars are heating up. Breadth was mixed, with advancers edging out decliners on the NYSE by about 100 issues, at 1,555. There were 46 new lows vs. 24 new highs.

But there was more volume on the downside.

Energy stocks were the laggards, dropping 1.7% as a group, after crude oil slid on inventory data showing a rise in stockpiles as well as the drag from the stronger greenback.

The tech sector was heavy, dampening spirits, with the likes of Apple Inc. (NASDAQ:AAPL) and Facebook Inc (NASDAQ:FB) sliding lower for losses of 2.1% and 2.7%, respectively.

Snap Inc (NYSE:SNAP) was among the most actively traded, surging more than 40% after reporting better-than-expected results for the first time as a public company thanks to a recent app redesign and a surge of new users. Boeing Co (NYSE:BA) gained 2.1%, helping lift the Dow Jones. And Hasbro, Inc. (NASDAQ:HAS) gained 88% to hit a six-month high after reporting strong results.

And finally, in Washington, Republicans and Democrats in the Senate have reportedly agreed to a two-year spending deal that would raise spending caps on defense and non-defense spending by $160 billion and $130 billion, respectively, over the next two years.

Conclusion

The weakness in Treasury bonds is shown by the downdraft in the iShares Barclays 20+ Yr Treas.Bond (ETF) (NASDAQ:TLT). Without a stabilization, it’s possible the market suffers another violent decline similar to what happened on Monday and Tuesday as inverse volatility ETFs blew up.

The next site of systemic carnage could be a risk parity fund that depends on stocks and bonds trading in opposite directions. The fact that both are falling right now hits these funds hard, resulting in margin calls and forced selling. The short VIX funds were “explicit” bets on volatility staying abnormally low; risk parity is an “implicit” bet on markets staying calm.

It’s the same thesis, just different implementation. And it too is now at risk.

If the bulls can’t step up here and force the CBOE Volatility Index lower to squeeze the late arriving volatility speculators, the turbulence could well worsen heading into Friday’s session. I still expect a one-week reprieve before the lows are tested, but that scenario is looking steadily less likely now.